Mortgage-interest deduction should be cut

Emily Washington
06:00p.m. Dec 26, 2012

While myriad factors contributed to the housing bubble burst – and the particularly slow recovery that has followed in California – federal policies aimed at encouraging homeownership deserve a solid share of the blame. As Washington struggles to get its fiscal house in order, eliminating the mortgage-interest tax deduction should be a key part of any deal.

This issue is particularly important for Californians. With one of the nation’s lowest rates of homeownership and some of the highest housing costs, it is especially vulnerable to policies that transfer wealth to homeowners and increase local housing costs. The federal home mortgage-interest tax deduction does just that.

The mortgage-interest deduction – which reduces federal revenues by about $100 billion each year – is an important component of Washington’s strategy to increase homeownership. The more buyers spend on their homes, the more they receive from the deduction. This distorts the housing market by encouraging them to purchase larger and more expensive homes than they would otherwise buy.

As the deduction is designed to benefit those who spend the most on mortgage interest, it also encourages consumers to take on greater debt. Lower-income homeowners who are likely to have smaller mortgages and interest payments may not receive the break at all because they are often better off taking the standard deduction. Of middle-income households earning between $50,000 and $75,000, the average benefit of the deduction is $179, and only about one-third of this group claims it. High-income taxpayers, on the other hand, disproportionately benefit: those with incomes over $200,000 receive an average of around $2,221, making it a highly regressive policy.

The Federal Reserve Bank of Boston has found that while the mortgage-interest deduction encourages homebuyers to purchase larger homes than they otherwise would, it is ineffective at encouraging people on the margins to buy – which is its stated intent. In other words, it favors established buyers over those who must choose between buying and renting by failing to create a big enough incentive to enter the market for the first time with a starter home.

In fact, the negative effects of this deduction fall hardest on renters. By providing tax advantages for homeownership, the federal government subsidizes all housing, artificially raising its price by increasing demand across the board. Renters don’t see their wealth rise along with home prices, making their housing needlessly expensive as government intervention keeps driving up its market value. And because they can’t use the deduction, renters pay relatively higher federal income taxes than homeowners do for the same services.

The mortgage-interest deduction often also favors those who live in suburbs over those who live in cities. As Harvard economist Ed Glaeser argues in “Triumph of the City,” the current policy drives many to abandon renting in the city for homeownership in the suburbs – simply to gain the tax deduction. While suburban communities are providing the large, single-family homes that the deduction creates demand for, cities are losing residents who are just beginning to prosper and pay more in taxes. The phenomenon occurs within city borders as well, where it leads to greenfield development at the outskirts of town instead of infill development. This requires municipalities to build entirely new infrastructure as they expand outward, rather than redeveloping existing areas that already have it.

We need to level the playing field for renters, low-income taxpayers and those with relatively small mortgages. Ending the deduction could reduce the federal deficit by $100 billion annually without increasing tax rates, and bring an end to a regressive program that fails to achieve its goal. It also would help reduce the tax incentives for owner-occupied homes that make it difficult for cities to compete with suburbs for residents.

The federal home mortgage-interest deduction is among a host of policies that encouraged Americans to take on more debt than they could afford, contributing to the housing bubble, its burst, the financial crisis and the ongoing slow recovery. Should Washington fail to correct these policies, it sets the stage for future crises. In the meantime, the deduction needlessly increases the cost of housing for those it purports to help. Californians – with high housing costs, low homeownership rates, and lasting damage from the housing crisis – should lead the fight against this detrimental policy.

Washington is a policy research manager for the Mercatus Center at George Mason University. She contributes to the blogs Neighborhood Effects and Market Urbanism.